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Be Careful Who You Indemnify

In the indemnity hierarchy, an owner typically requires its general contractor to indemnify the owner from and against “any and all claims arising out of, related to, arising out of, etc.” the general contractor’s scope of work. Similarly, the general contractor will require indemnification from its subcontractors. This dynamic continues with each party pointing to the next down a proverbial “indemnity ladder.”  In this typical scenario, it is good to be the “owner,” perched high atop the indemnity hierarchy.

However, in the case of American Title Insurance Company v. Spanish Inn, (California Court of Appeals for the Fourth District, August 14, 2015), the tables were turned on the “owners” when a title insurer was able to utilize an indemnity agreement to seek reimbursement against the owners of the insured property.

Facts:
​​Spanish Inn, Inc. (“Spanish Inn”) entered into a $6 million construction loan agreement with Nara Bank for the construction of a hotel in Palm Springs, California. Nara Bank recorded a construction deed of trust against the property to secure its loan. Moreover, Nara Bank also required that Spanish Inn obtain a title insurance policy to protect against losses arising from mechanics liens.

In satisfaction of this obligation, ​​Spanish Inn obtained a title insurance policy from First American Title Insurance Company (“First American”). As a condition of issuing the title insurance policy, First American required that Spanish Inn and the other owners of the property (“Defendants”) enter into an indemnity agreement whereby they agreed to indemnify First American if any mechanics liens were recorded on the property.

Of course, as is all too typical in construction projects, delays and cost increases later caused Spanish Inn to miss the completion deadline under the construction loan agreement.  As a result, Nara Bank foreclosed on its deed of trust.

Pacifica L 39, LLC (“Pacifica”) purchased the property in a nonjudicial foreclosure.  When two contractors filed suit to foreclose on the mechanics liens they recorded on the property, Pacifica tendered the claims to First American, who accepted the tenders.

First American then demanded the Defendants defend and indemnify First American under the terms of their indemnity agreement with First American.  Defendants refused. First American then sued the Defendants seeking $250,876.53 in damages, primarily comprised of $207,119.58 in attorney’s fees incurred by First American in defending against the mechanics liens, $20,950 paid by First American to settle one of the mechanics lien claims, and 10% interest on the total.

While the case was pending in the trial court, First American filed a motion for summary judgment on its claims against the Defendants. The Defendants opposed the motion arguing the mechanics liens fell within a coverage exclusion in the title insurance policy for “liens . . . created, suffered, assumed or agreed to by the insured claimant.”

According to the Defendants, Nara Bank “created” the mechanics liens by failing to provide sufficient funding.  By failing to provide sufficient funding, it caused the two contractors to record mechanics liens on the property. Thus, they argued, First American was not required to defend against the mechanics liens under the title insurance policy and the Defendants in turn were not required to indemnify First American.

The trial court ruled against the Defendants, who appealed.

Ruling:
​​On appeal, the Appellate Court explained that contractual indemnity has three elements. The indemnitee (i.e., the person being indemnified) must show that:

  • the liability is covered by the contract;
  • that the liability existed; and
  • the extent thereof.

Addressing each of these elements in turn, the Appellate Court indicated the Defendants did not appear to contest that First American’s claim “is covered by the contract” and so the first element was satisfied.

As to the second element, “that liability existed,” the Appellate Court held liability did in fact exist, although on different grounds than the trial court had ruled. Rather than falling outside the “coverage exclusion” as the trial court had found, the Appellate Court held that a provision in the indemnity agreement granting First American the right to conclusively determine coverage under the title policy was binding on the Defendants. Specifically, the relevant provision provided:

5.6 Determination of Coverage. Any determination of coverage by First ​​​American shall be conclusive evidence that the matter is within the Title ​​​Policy coverage as to the Mechanics Liens for purposes of this Agreement.​​

Because First American had determined the mechanics liens were covered under the title insurance policy, and its determination was conclusive, Defendants were bound by First American’s determination and, therefore, obligated to indemnify First American.
​​As to the third element, “the extent [of liability],” the Appellate Court held that First American had satisfied this element through declarations of its in-house claims counsel together with the outside counsel’s billing statements which established the extent of legal expenses incurred by First American to defend against the mechanics lien claims.

The Appellate Court rejected the Defendants’ argument that First American’s conclusive right to determine coverage was subject to the implied covenant of good faith and fair dealing. “[A]lthough it has been said the implied covenant finds particular application in situations where one party is invested with a discretionary power affecting the rights of another,” explained the Appellate Court, “if the express purpose of the contract is to grant unfettered discretion, and the contract is otherwise supported by adequate consideration, then the conduct is, by definition, within the reasonable election of the parties and can never violate an implied covenant of good faith and fair dealing.”

Stated differently:  if your agreement to indemnify someone is clear and explicit, then the courts are going to hold you to it.

ABOUT THE AUTHORS
David Ramirez is a Senior Counsel at TYSON & MENDES, LLP, and primarily represents clients in complex litigation, including construction defect, insurance law, property disputes, and product liability. Mr. Ramirez was recently named as a “Top Lawyer” in California for “Litigation” in the February 2015 issue of San Diego Magazine. Contact Mr. Ramirez at 858.459.3365 or dramirez@tysonmendes.com.

Patrick Mendes is a Partner at Tyson & Mendes and specializes in professional liability, insurance coverage, architects & engineers, real property disputes, and bad faith litigation. Contact Mr. Mendes at 858.459.1953 or pmendes@tysonmendes.com.

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